Index Funds Outperform Managed Funds

It has been a perennial debate as to which type of fund actually produces a better return for the investor, index or actively managed. According to a recent article in the New York Times, there is new evidence to suggest that the average should invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

As Mark Hulbert points out, basic stock market index funds are general designed to do little more than match the returns achieved by a market benchmark. So, one would imagine that in a bad year for stocks, index funds would not look very attractive. Not so.

It seems that after fees and taxes, it is extremely rare for actively managed funds or hedge funds to perform better than a simple index fund. This starling conclusion was based upon the findings of research undertaken by Mark Kritzman, President and CEO of Windham Capital Management of Boston. Whilst the analysis is based on US figures, taxes in Australia are somewhat higher than those in the US, so it is likely that the conclusions are at least partially relevant to that country as well. If nothing else they provide food for thought.

Kritzman wanted to accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund, including transaction costs, taxes and management and performance fees. Apparently it is very difficult to measure these costs accurately as the amount taken out by taxes, for example, depends on the specific combination of positive years and losing ones, as well as the order in which they occur.

Kritzman devised a sophisticated means of taking such contingencies into account before calculating the average return over a hypothetical 20-year period, net of all expenses, for three hypothetical investments. Namely: a stock index fund with an annualized return of 10%, an actively managed mutual fund with an annualized return of 13.5% and a hedge fund with an annualized return of 19%. The volatility of the three funds' returns, along with their turnover rates, transaction fees and management and performance fees, was based on what he determined to be industry averages.

Just to put that in context, if you started with $1000 in each fund, without the impact of volatility and expenses, by the end of the 20 year period you would have approximately $6000 in the index fund, just over $11,000 in the mutual fund and more than $27,000 in the hedge fund. Despite that, Kritzman found, net of all expenses, including taxes for a resident in the highest tax brackets, the fund providing the best return for the investor was the index fund.

Kritzman discovered that whilst the actively managed fund beat the index fund by 3.5 percentage points a year, and the hedge fund beat the index fund by 9 percentage points a year, their expenses more than consumed this differential.

This begs the question, if such a level of out-performance fails to overcome the drag of expenses, what level of performance do actively managed funds and hedge funds need to obtain to prevent this occurring? According to Kritzman, just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. If that was not bad enough, the hedge fund would have to outperform the index fund by at least 10 percentage points every year!

You would think that given all the hype surrounding active funds and hedge funds, this would not be difficult. Sadly the opposite is true, even in the US where there is an amazing choice available to the average investor.

If you analyse the 452 domestic US equity mutual funds in the Morningstar database that existed for the 20 years through January of this year, only 13 beat the Standard & Poor's 500-stock index by at least four percentage points a year, on average, over that period. That's less than 3% of the funds in that database.

But wait there's more.

Apparently, the above statistics actually overstate the real situation. As finance professor Wermers points out, it's one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. In fact he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well. (This brings back memories of the work I did years ago on Chasing Last Year's Winners.)

I hate to say it, but it gets worse.

Professor Wermers believes that it highly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade, achieved that return almost entirely due to luck alone. Consequently according to Wermers "By definition, therefore, such a fund could not have been identified in advance".

Kritzman argues that "It is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth." He went on to add that those who still insist on an actively managed fund are almost certainly "deluding themselves."

Pretty strong language. As I said earlier, definitely food for thought.

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